Eliminate Disaster Stocks from Your Portfolio

Back in 2002, I addressed the issue of limiting the downside of disaster stock holdings (see Risk Management of "Fiasco" Stocks).

Today, we go to Clay Allen of Market Dynamics for more color on the same:

“It has been shown that long-term investors stay with stocks that don’t provide good performance for far too long. This seems to be such a strong tendency for many investors that considerable care must be taken to avoid this serious source of major losses in the portfolio. How does the investor guard against his own behavior that allows him to hold poorly performing stocks for far too long?”

“The investor must make a commitment to eliminating poorly performing stocks just as soon as they can be identified. The best way to identify poorly performing stocks is with a long-term chart that shows relative strength. The investor must have a very clear idea about what constitutes unacceptable performance. There must be a predetermined decision point that cannot be reached without action being taken to sell the stock.”

“It is often surprising how correct the collective judgment of the market can be when a stock starts to have performance problems. The discounting process of the market and resulting poor performance of the stock starts to reveal the onset of negative developments in the financial performance of the company long before those fundamentals is made public.”

“The onset of poor market performance is one of the best recommendations a long-term investor can make to eliminate the bad stock from a portfolio. However, it seems common for long-term investors to either overlook the poor performance or assume that it is a temporary development and believe that that better market performance will surely follow. Poor performance is euphemistically called a correction and it is essentially a denial that the stock did not go up as expected.”

“It then becomes common for the long-term investor to believe that the stocks can’t be sold because it has gone down too much. Too much relative to what? The down trend persists and the long-term investor becomes psychologically trapped in the poorly performing stock.”

“The best defense against these common difficulties is to measure the performance of each stock in the portfolio. Very clear rules can be formulated that will force the sale of a poorly performing stock while the damage is still small.”

Terrific advice . . .



Charting Performance
Analyst Uses P&F Charts, Relative Strength To Improve Portfolios
VOLUME 6, I SS U E 1 6
Welling@Weeden, SEPTEMBER 10, 2004

"Say It Ain’t So, Joe…"
P. Arthur Huprich, CMT
Raymond James, September 29, 2005

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  1. spruce lee commented on Oct 16

    this is the method i use (and forgive me if all this comes off as pedestrian or “basic”).

    I call it the 3R system — it’s not proprietary at all – it’s more like an amalgation of things i’ve read…

    I attach 3 R’s to every equity i buy or analyze. As you’ll see it’s very “top-down” in its orientation.

    Market Risk

    What is the overall “mood” of the market and by extension the economy?

    I’m a firm believer that stocks make for great barometers of economic data. this is where you keep vigiliance over rates, LEIs etc, GDP, inventory, and employment #s…

    Industry/Sector risk

    If energy is high, one would ideally short airlines and go long oil.

    At the end of the day, you don’t want to invest in sectors and industries that are roiling from cyclical downturns, negative press, excessive litigation, etc…

    Close to 50% of your stocks return stems from the sector it’s in, so sector factors is important.

    if you ever hear investors bitch and moan about the hot company they bought but are losing money on — nine out of 10 times, it’s not the stock that’s underperforming…it’s the sector.

    Company-specific risk

    here’s where it gets fun. pore over the 10Ks, listen in on conference calls, read the research reports. study the charts, insider activity, institutional ownership patterns, & short interest.

    a couple of years ago I read about economic moat in a morningstar report — i was blown away and now add it to my criteria list.

    moat helps you sleep better art night knowing your holdings are less susceptible to competition.

    but don’t use moat as the sole reason to buy a stock — if moat was king, eBay and MSFT would be returning more to their shareholders…


    And those are the 3 R’s.

    Knowing them isn’t enough…what you do with them is what counts.

    As soon as 2 of the 3 R’s turn negative, it’s time to blow the position or cut that particular stock from your watch list…

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